JPMORGAN'S TOM LEE: We Are On The Cusp Of A 'Regime Shift' In The Stock Market

One of the peculiar features that characterized the current rally in the stock market that started back in September - at least for the first few months - was the outperformance of defensive stocks versus cyclical names that tend to do better in times of economic expansion.

Typically, cyclicals are the ones leading the way when the stock market is pushing to new all-time highs, levels it finally overtook early in the second quarter. Yet defensives were the ones outperforming.

At the time, several analysts noted this oddity. One popular explanation was that it was part of investors' reach for yield (in general, defensives pay higher dividends than cyclicals).

Mitsubishi UFJ Morgan Stanley Securities
Now, that trade is finally starting to turn around, and cyclicals are beginning to outperform against defensives once again.

JPMorgan Chief U.S. Equity Strategist Tom Lee describes this as a "regime change" taking place in the stock market.

Lee recommended investors rotate toward cyclicals and away from defensives at the beginning of the second quarter in early April.

In a note to clients, he writes:

The recent mixed commentary from Fed officials, volatility in treasuries and JGB (Japan bonds), has investors focused on the timing of Fed tapering. More significantly, we believe this may be signaling a regime shift, not of Fed watching, but rather for investors to shift away from "bond-like" equities, favoring equities with leverage to stronger GDP growth (read as cyclicals) and inflation-protection over current yield.

In other words, this is arguing that the environment favoring cyclical is not merely short- term (we had argued that investors need to be cyclical since start of 1Q mostly due to evidence of capitulation, see "1Q Laggards..." dated 4/4/13) but rather, there is validity in arguing the positive long-term case for Cyclicals starts now (in our May 10th "Circle of Life", we argued the anticipated environment 3-5 years out looks a lot like the early 90s, favoring cyclicals).

With the prospect of rising interest rates seeping into both bond and equity markets, making "bond-like" defensive stocks less attractive, Lee lays out the case for cyclicals in a few main points: